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June 21, 2013

Why Competition May Boost Your Income

New research offers some counterintuitive ideas on advisors’ pay—and reinforces some intuitive ones as well

Are financial advisors paid too much?

There is a notion prevalent in the academic literature and at the popular level that financial advisors claim an undue share of the national wealth. Specifically, some question if something nefarious such as unfair, rent-seeking behavior might explain why total compensation of financial intermediaries is at all-time high of 9% of GDP.

A newly published academic paper takes a far more benign view of financial sector compensation, arguing that the financial sector’s share of GDP is related to the growing importance of wealth preservation in a maturing economy.

The 40-page working paper by Nicola Gennaioli of Università Bocconi, Andrei Shleifer of Harvard University and Robert Vishny of the University of Chicago—titled “Finance and the Preservation of Wealth”—also finds other causes of the financial sector’s rise and fall in economic history.

Financial advisors will not be surprised that declines in productivity and, especially, trust reduce opportunities for advisors in the long run, though they may be surprised that in the short run productivity drops enhance their prospects.

“This is because the drop in productivity reduces GDP and growth opportunities a lot but leaves the wealth preservation service of the financial sector relatively unaffected,” the authors writes. “As a consequence, the financial sector shrinks less than GDP, increasing the share of national income going to finance.”

Gennaioli, Shleifer and Vishny point out that the finance sector’s share of national wealth ebbs and flows over the years, rising from 2% of GDP in the 1940s to about 8% at the time of the financial crisis.

Its level before the Great Depression was 6%, but that earlier economic crisis “in all likelihood combined a decline in productivity with a sharp decline in trust in the financial system,” which took fully 40 years to reverse, assuming prewar levels only in the 1980s.

That financial intermediaries’ share of national wealth rose to prewar levels decades after U.S. productivity and wealth surpassed prewar levels illustrates the key role trust plays in lubricating the financial economy.

A related and counterintuitive insight is that competition in the seemingly crowded financial sector increases intermediaries’ wealth. That broker down the street is not eating your lunch but rather adding to the overall level of trust.

“Part of the reason why the income of the financial sector grows over time is that the entry of new intermediaries increases the proximity of money managers to investors, increasing risk taking and the size of the financial sector,” the three researchers write.

New entrants “got ‘closer’ to their clients and therefore became more trusted,” they add.

Gennaioli, Shleifer and Vishny refer to financial intermediaries—bankers, brokers, wealth planners, or money managers—as “money doctors,” suggesting that an innate lack of confidence draws savers to professionals without whom they would be putting their money into mattresses and gold.

Economic growth and trust, far from mere slogans, are the tide upon which financial advisors’ careers rise.

“An important byproduct of economic growth, entry by financial intermediaries and reduction in fees is that investors allocate increasing shares of their wealth to intermediated financial products, rather than to self-storage” [i.e., mattresses and gold].

Indeed, a rising level of trust seems to bring with it increasingly sophisticated financial products and commensurate increases in fees.

“We draw a sharp distinction between self-storage, which requires no intermediation, and risky investments, which require money managers. In reality, the gradation is more continuous, from cash in mattresses and gold, to bank savings, to liquid market investments, to illiquid investments such as private equity and hedge funds, with increasing amounts of intermediary attention (and cost).”

In another counterintuitive idea, diminishing returns on capital over time reduce unit management fees. Yet, “despite this reduction in unit fees, the aggregate income earned by money managers grows over time. This is because the growth in the size of the intermediated wealth more than compensates for the reduction in unit fees, and causes financial sector income to rise over time. In our model financial sector income grows faster than value added, so the ratio of financial sector income to GDP grows over time,” the authors write.

For financial advisors, this sounds too good to be true. The task of wealth preservation keeps their incomes rising—unless and until…“a drop in either productivity or trust causes financial intermediation to shrink.”

As previously mentioned, a drop in productivity actually enhances intermediaries’ wealth in the short term because advisors’ wealth preservation role remains relatively unaffected, thus increasing GDP share as other sectors decline.

A decline in trust, however, sends a shock to the system.

“As trust suddenly dissipates (owing, for instance, to a financial crisis), individual [sic] take money out of the financial sector and put it into mattresses (self-storage). This reduces financial intermediation and the financing of profitable investment opportunities. Income reductions reduce the stock of wealth, further undermining the ability to finance investment in the future. This process generates a persistent contraction in financial intermediation and income until the new, lower, equilibrium is attained,” the authors write.

The working paper is filled with equations and technical jargon, but it offers some fresh thinking on what advisors need to fear (scandal, lack of trust, economic downturn) and what they perhaps needn’t fear (competition). None of the paper’s three authors could be reached by AdvisorOne.